Trust Creation And The Tax Consequences

Malcolm Finney looks at some of the advantages that a family trust can offer. 

The popularity of trusts as part of the tax planner’s armoury continues despite their tax effectiveness having been eroded over the past decade. Nevertheless, in the right set of circumstances a family trust can offer both tax effectiveness and flexibility for the future.

Lifetime or will trust

A trust can be created in lifetime (an ‘inter-vivos’ trust) or under a will (a will trust). The mechanics of formation are basically the same.

A trust is created either by the owner of property declaring that henceforth he will hold the property on trust for (beneficiaries) A, B, C etc. or by transferring the property to trustees to hold on trust for (beneficiaries) A, B, C etc. The effect is that legal title to the property is then held by trustees who hold the property on trust for the benefit of the beneficiaries. The person creating the trust (usually referred to as the ‘settlor’) also sets down the terms of the trust.

Harry has a portfolio of various share investments.

He decides to transfer the investments to trustees (he states they are to be his two brothers) to hold on discretionary trust for his son and daughter and his three nieces.

A trust can be used to mitigate tax liabilities and/or facilitate general planning for the family. 

Mr Smith’s estate (i.e. his total assets less liabilities) is worth £525,000. If he dies leaving his estate to his son and daughter, an inheritance tax (IHT) charge of £80,000 arises (i.e. 40% x (£525,000 - £325,000)). He therefore transfers £200,000 worth of unlisted share investments into trust for his son and daughter. The transfer into trust does not give rise to an IHT charge, assuming his nil rate band of £325,000 is available at that time. On his death, the shares in trust are not subject to IHT as they are no longer part of his estate. 

Mr Brown is married with three children. His estate is worth £1 million. He wants to provide for his family but does not want the capital to be spent by his wife (i.e. he wants his children to ultimately inherit the capital). Mr Brown leaves the whole of his estate in trust with his wife as life tenant and remainder to his three children. As life tenant, his wife has the right to continue to live in their home (with the children) until she dies and she is also entitled to all the income generated on the trust assets. She cannot access the trust’s assets, which remain in the trust under the control of the trustees until she dies, at which time they become the property of the three children (i.e. on her death the trust ceases to exist). 

Mr Green has five grandchildren. He is concerned about their future well-being. He has no idea how they will each fare in the world. He therefore sets up a discretionary trust (transferring two buy-to-let properties) with the grandchildren as beneficiaries. As the trust is discretionary this means that the trustees can decide how and when to provide for each beneficiary in the light of circumstances at the time. 

Setting up a trust may give rise to a charge to capital gains tax (CGT). However, any such charge may be capable of being deferred (under the CGT ‘hold-over relief’ provisions). Whilst deferral would be possible in Mr Green’s case and also Mr Smith’s cases (if his son and daughter were aged 18 or over) this would not be possible for Mr Brown. In Mr Brown’s case the trust is a ‘settlor-interested’ trust which means that he himself, his spouse and/or children below age 18 may benefit under the trust, which results in hold-over relief being denied. In Mr Brown’s case, it would therefore make sense to try to settle assets which have not increased significantly in value, thus mitigating any CGT charges. 

Trusts are very useful for family tax planning purposes. However, the tax rules applicable to trusts (i.e. set up, running and collapsing) can be very complex and are not the province of the DIY tax planner; professional advice is a must.